Sunday, August 5, 2012

From Euro Area Summit to the periphery "bridge loan" - a quick recap of major events in the Eurozone

The news from the Eurozone continues to dominate markets' direction. Yet the information from the area has been incredibly confusing, even for many who reside in the EU. The mass media has not made things easier by jumping from one event to another, often without connecting these events together. We've gotten numerous requests to try to clarify some of the key events that have taken place just in the last couple of months and what they mean for the euro area going forward.

Here is a highly simplified overview using basic diagrams. Solid lines indicate what actually transpired, while dashed lines show expectations at the time.

June 2012:

Between escalating risks of the Spanish banking system failure and Mario Monti's efforts to stabilize Italy's government funding costs, pressure was mounting on the Eurozone to take immediate action. Spain and Italy had somewhat diverging needs, but they came together to ask the Eurozone "core" to come to a decision.

And with the brand new Socialist government in France lead by Hollande, Monti and Rajoy found a new ally. Hollande heralded a shift in the balance of power in the Eurozone (as predicted back in January). Together the three were able to pressure Germany into a new compromise. They reached a broad agreement to centralize bank regulation, provide bailout funds to Spain's banks, and most importantly give the European Stability Mechanism (ESM) the ability to buy periphery bonds in a "flexible manner" and allow the bailout vehicle to rescue banks directly. This was a broad agreement with no visible path to implementation. But as we know from 2011, the devil of the Eurozone multiple proposed solutions has always been in the detail, which was entirely missing by the conclusion of the Euro Area Summit.

July 2012 (first 3 weeks):

It didn't take long for the markets to become disillusioned in the agreement reached at the summit as the implementation got bogged down in the black hole of the EU bureaucracy. The existing Eurozone structures were never set up to decisively deal with rapidly changing market pressures. Spanish yields and spreads hit new records and it became obvious that Spain is now shut out of the capital markets. What's more, due to a change in collateral rules at the ECB, the Spanish banking system (which itself is in the process of receiving a bailout) would not be able to come to the government's rescue as it did in the past. And a Eurozone-wide rescue of Spain was out of the question as it would dwarf that of Ireland, Greece, and Portugal.

Last two weeks:

Once the leadership came to the conclusion that the markets won't wait for the new "empowered" ESM - which is not close to being set up, it was time to find some way to "bridge" to the ESM event. In leveraged finance, bankers use what's called "bridge loans" (short-term loans) to provide financing to a company until it is able to bring a bond deal (or even an IPO) into the market. The Eurozone needed one of those and the ECB became the only available option. At this stage, given how desperate the situation has become, the ECB was no longer acting as an "independent" central bank. Instead it was drafted to help hold off the crisis until the euro are institutions put in place the ESM "solution". Using the ECB to only tackle the short end of the curve was a new compromise with Germany that would provide this "bridge loan" to the periphery without taking on long term risk.

Bloomberg: - Members of German Chancellor Angela Merkel’s coalition parties signaled they won’t stand in the way of European Central Bank chief Mario Draghi’s plan to buy government bonds.

Germany knows that once the ESM is in place, they can control the bond-buying process (to avoid taking "excessive" risks) via their veto power. In the mean time Draghi was brought in to "save the day" (without the full knowledge of some other ECB central bankers) .

So what happens now? The ECB will try to quickly implement a backstop program to keep short term periphery rates low to allow Spain and Italy to roll short-term paper, creating a low cost "bridge loan". In the mean time the Eurozone bureaucratic machine will try to implement the ESM structure as envisaged at the Euro Area Summit. But as the area recession deepens, the implementation becomes a race against time and more market volatility is inevitable.